Demand

ECON201- MICROECONOMICS
Spring 2024
Consumer Theory
• We consider a rational consumer.
• We address the following two questions:
• Which combinations of goods is the consumer able to buy?
• B(p,m)
• Among the combinations of goods that the consumer is able to buy, which
combination(s) does the consumer prefers to buy?
• ≿ ⇔ u(x)
• Utility maximization problem:
Ordinary demand for
maxx u(x)
good i:
s.t. x ∈ B(p,m)
𝑥#∗ (𝑝, 𝑚)
2
Demand Functions: Comparative statics analysis
• The study of how optimal consumption bundles x1*(p1, p2, m) and x2*(p1, p2, m) change
as prices (p1, p2) and income (m) change.

TODAY:
• Question 1: how does x1*(p1, p2, m) change with m (while p1, p2 are fixed)?
• Question 2: how does x1*(p1, p2, m) change with p1 (while m, p2 are fixed)?
• Question 3: how does x1*(p1, p2, m) change with p2 (while m, p1 are fixed)?

NEXT LECTURE:
• How to decompose the effect of price changes on demand?
Effect of income changes
• How does the value of x1*(p1, p2, m) change as m changes, holding both p1 and p2
constant?
Effect of income changes
Effect of income changes
Effect of income changes
Effect of income changes
• The curve that unites the optimal choices for various levels of income is called
income offer curve or income expansion path.
• Axes are 𝑥! and are 𝑥"
• A plot of quantity demanded (of good i) against income is called an Engel curve.
• Axes are are 𝑥# and m
Effect of income changes: Engel Curve
Effect of income changes: Engel Curve
Effect of income changes: Engel Curve
Engel curves: Cobb-Douglas utility function
• Two goods (n=2)
• 𝑝% > 0 , 𝑝& > 0 , 𝑚 > 0
• 𝑢 𝑥% , 𝑥& = 𝑥%' 𝑥&( , a > 0, b > 0
• Optimal consumption bundles:

max 𝑥%' 𝑥&( 𝑎 𝑚

)! ,)" 𝑥%∗ 𝑝% , 𝑝& , 𝑚 =
𝑎 + 𝑏 𝑝%
𝑠. 𝑡. 𝑝% 𝑥% + 𝑝& 𝑥& ≤ 𝑚
𝑏 𝑚
𝑥&∗ 𝑝% , 𝑝& , 𝑚 =
𝑎 + 𝑏 𝑝&
12
Engel curves: Cobb-Douglas utility function

• Rearranged to obtain:

• Engel curve for good 1:

• Engel curve for good 2:

Engel curves: Cobb-Douglas utility function

• Engel curve for good 1

• Engel curve for good 2

Engel curves: Perfect complementary preferences
• Two goods (n=2)
• 𝑝% > 0 , 𝑝& > 0 , 𝑚 > 0
• 𝑢 𝑥% , 𝑥& = min{𝑥% , 𝑥& }
• Optimal consumption bundles:

+
𝑥%∗ 𝑝% , 𝑝& , 𝑚 = 𝑥&∗ 𝑝% , 𝑝& , 𝑚 =
,! -,"

15
Engel curves: Perfect complementary preferences

16
Engel curves: Perfect complementary preferences

17
Engel curves: Perfectly substitutable preferences
• Two goods (n=2)
• 𝑝% > 0 , 𝑝& > 0 , 𝑚 > 0
• 𝑢 𝑥% , 𝑥& = 𝑥% + 𝑥&
• Can you draw the Engel curves? (use ordinary demand functions
from Lecture 8 Slides)

18
Effect of income changes: Engel Curve
1. Are the Engel curves always straight lines?
2. Are the Engel curves always upward sloping?

19
Effect of income changes: Engel Curve
1. Are the Engel curves always straight lines?
• No, Engel curves are straight lines if the consumer’s preferences are
homothetic.
• A consumer’s preferences are homothetic if and only if the following holds
for every k>0:

• That is, the consumer’s MRS is the same anywhere on a straight line drawn
from the origin (Example: CES Utility Functions).

20
Effect of income changes: Engel Curve
• Homothetic preferences: the consumer’s MRS is the same anywhere
on a straight line drawn from the origin.

21
Effect of income changes: Engel Curve
• Are preferences always homothetic?
• No, quasi-linear preferences are non-homothetic.
%/&
• Example: 𝑢(𝑥% , 𝑥& )= 𝑥% + 𝑥& [PS 3 - Q3]

MU% 1
MRS = − = − .0
MU& 2x%

• MRS is not the same on a straight line from the origin.

22
Income Changes – Quasilinear Utility

• Each curve is a vertically

shifted copy of the others.

• Each curve intersects both

axes.
Income Changes – Quasilinear Utility
Income Changes – Quasilinear Utility
Income Changes – Quasilinear Utility
Effect of income changes: Engel Curve
1. Are the Engel curves always straight lines?
2. Are the Engel curves always upward sloping? No!
• A good for which quantity demanded rises with income is called normal.
• Therefore, a normal good’s Engel curve is positively sloped.
• A good for which quantity demanded falls as income increases is called
income inferior.
• Therefore, an income-inferior good’s Engel curve is negatively sloped.

27
Income Changes – Goods 1 & 2 Normal
Income Changes – Good 2 Is Normal, Good 1 Becomes Inferior
Income Changes – Good 2 Is Normal, Good 1 Becomes Inferior
Income Changes – Good 2 Is Normal, Good 1 Becomes Inferior
Demand Functions: Comparative statics analysis
• the study of how optimal consumption bundles x1*(p1, p2, m) and x2*(p1, p2, m)
change as prices (p1, p2) and income (m) change.
• Question 1: how does x1*(p1, p2, m) change with m (while p1, p2 are fixed)?
• Question 2: how does x1*(p1, p2, m) change with p1 (while m, p2 are fixed)?
• Question 3: how does x1*(p1, p2, m) change with p2 (while m, p1 are fixed)?
Own-Price Changes
• How does x1*(p1, p2, m) change as p1 changes, holding p2 and m constant?
• Suppose only p1 increases, from p1ʹ to p1ʺ and then to p1‴.
Own-Price Changes
Own-Price Changes
Own-Price Changes
Own-Price Changes
Own-Price Changes
Own-Price Changes
Own-Price Changes
Own-Price Changes
Own-Price Changes
Own-Price Changes
Own-Price Changes
Own-Price Changes
• The curve containing all the utility-maximizing bundles traced out as 𝑝1 changes,
with 𝑝2 and 𝑚 constant, is the p1-price offer curve.
• Given a fixed 𝑝2, 𝑚, the equations 𝑥!(𝑝1, 𝑝2, 𝑚) expresses consumption of 𝑥!∗ as a
function of its own price 𝑝!. This function is an ordinary demand function. Like
any function it can be graphed and differentiated.
• The plot of the x1-coordinate of the 𝑝!-price offer curve against 𝑝! is the ordinary
demand curve for commodity 1.
• The economists are in the perverse and unchangeable habit of graphing 𝑝!on the
vertical axis and 𝑥! on the horizontal axis.
Ordinary Goods
• A good is called ordinary if the quantity demanded of it always increases as its
own price decreases.
Giffen Goods
• If, for some values of its own price, the quantity demanded of a good rises as its
own price increases, then the good is called Giffen.
Demand function and price-offer curve: Cobb-Douglas utility
function
• Two goods (n=2)
• 𝑝% > 0 , 𝑝& > 0 , 𝑚 > 0
• 𝑢 𝑥% , 𝑥& = 𝑥%' 𝑥&( , a > 0, b > 0
• Ordinary demand functions:

max 𝑥%' 𝑥&( 𝑎 𝑚

)! ,)" 𝑥%∗ 𝑝% , 𝑝& , 𝑚 =
𝑎 + 𝑏 𝑝%
𝑠. 𝑡. 𝑝% 𝑥% + 𝑝& 𝑥& ≤ 𝑚
𝑏 𝑚
𝑥&∗ 𝑝% , 𝑝& , 𝑚 =
𝑎 + 𝑏 𝑝&
48
Demand function and price-offer curve: Cobb-Douglas utility
function

49
Demand function and price-offer curve : Perfect complementary
preferences
• Two goods (n=2)
• 𝑝% > 0 , 𝑝& > 0 , 𝑚 > 0
• 𝑢 𝑥% , 𝑥& = min{𝑥% , 𝑥& }
• Ordinary demand functions:

+
𝑥%∗ 𝑝% , 𝑝& , 𝑚 = 𝑥&∗ 𝑝% , 𝑝& , 𝑚 =
,! -,"

50
Demand function and price-offer curve : Perfect complementary
preferences
Inverse Demand Function
• Usually, we ask “Given the price for commodity 1 what is the quantity demanded
of commodity 1?”
• But we could also ask the inverse question “At what price for commodity 1 would
a given quantity of commodity 1 be demanded?”

Taking quantity demanded as given

and then asking what must be price
describes the inverse demand
function of a commodity.
Inverse Demand Function Examples
am
A Cobb-Douglas example: x =*
1 is the ordinary demand function and
(a + b) p1

am
p1 = is the inverse demand function.
(a + b) x1
*

m
A perfect-complements example: x =*
1 is the ordinary demand function and
p1 + p2
m
p1 = * - p2 is the inverse demand function.
x1
Demand Functions: Comparative statics analysis
• the study of how ordinary demands x1*(p1, p2, m) and x2*(p1, p2, m) change as
prices (p1, p2) and income (m) change.
• Question 1: how does x1*(p1, p2, m) change with m (while p1, p2 are fixed)?
• Question 2: how does x1*(p1, p2, m) change with p1 (while m, p2 are fixed)?
• Question 3: how does x1*(p1, p2, m) change with p2 (while m, p1 are fixed)?
Cross-Price Effects
• If an increase in p2
• increases demand for commodity 1 then commodity 1 is a gross substitute
for commodity 2.
• reduces demand for commodity 1 then commodity 1 is a gross complement
for commodity 2.
Cross-Price Effects
%
• Perfect complements example: 𝑥!∗ 𝑝!, 𝑝", 𝑚 = &! '&"
)*!∗ &! ,&" ,% %
• )&"
=− &! '&" " <0
• commodity 2 is a gross complement for commodity 1.
, %
• Cobb-Douglas example: 𝑥!∗ 𝑝!, 𝑝", 𝑚 = ,'- &
!
)*!∗ &! ,&" ,%
• )&"
=0
• commodity 2 is neither a gross complement nor a gross substitute for
commodity 1.
Summary
• Demand for a good may depend on that good’s price, other goods’ price, and
income.
• Effect of income changes:
• Normal goods: demand increases as income increases.
• Inferior goods: demand decreases as income increases.
• Effect of price changes:
• Ordinary goods: demand decreases as own price increases.
• Giffen goods: demand increases as own price increases.
• Complements vs. Substitutes:
• If demand for good 1 increases as the price of good 2 increases they are
(gross) substitutes.
• If demand for good 1 decreases as the price of good 2 increases they are
(gross) complements.
Demand Functions: Comparative statics analysis
• the study of how ordinary demands x1*(p1, p2, m) and x2*(p1, p2, m) change as prices (p1,
p2) and income (m) change.

TODAY:
• Question 1: how does x1*(p1, p2, m) change with m (while p1, p2 are fixed)?
• Question 2: how does x1*(p1, p2, m) change with p1 (while m, p2 are fixed)?
• Question 3: how does x1*(p1, p2, m) change with p2 (while m, p1 are fixed)?

NEXT LECTURE:
• How to decompose the effect of price changes on demand?